[Federal Register: December 27, 2006 (Volume 71, Number 248)]
[Rules and Regulations]
[Page 77594-77612]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr27de06-8]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[TD 9305]
RIN 1545-AW50
Source of Income From Certain Space and Ocean Activities; Source
of Communications Income
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations under section 863(d)
governing the source of income from certain space and ocean activities.
It also contains final regulations under section 863(a), (d), and (e)
governing the source of income from certain communications activities.
In addition, this document contains final regulations under section
863(a) and (b), amending the regulations in Sec. 1.863-3 to conform
those regulations to these final regulations. The final regulations
primarily affect persons who derive income from activities conducted in
space, or on or under water not within the jurisdiction of a foreign
country, possession of the United States, or the United States (in
international water). The final regulations also affect persons who
derive income from transmission of communications.
DATES: Effective Date: These regulations are effective December 27,
2006.
Applicability Date: For dates of applicability, see Sec. 1.863-
8(h) and Sec. 1.863-9(l).
FOR FURTHER INFORMATION CONTACT: H. Michael Huynh, (202) 435-5161 (not
a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in these final regulations
have been reviewed and approved by the
[[Page 77595]]
Office of Management and Budget (OMB) in accordance with the Paperwork
Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545-
1718.
The collections of information in these final regulations are in
Sec. Sec. 1.863-8(g) and 1.863-9(k). This information is required by
the IRS to monitor compliance with the Federal tax rules for
determining the source of income from space or ocean activities, or
from transmission of communications.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number assigned by the Office of
Management and Budget.
The estimated annual burden per respondent is 5 hours.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer,
SE:W:CAR:MP:T:T:SP, Washington, DC 20224, and to the Office of
Management and Budget, Attn: Desk Officer for the Department of the
Treasury, Office of Information and Regulatory Affairs, Washington, DC
20503.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
Congress enacted section 863(d) and (e) as part of the Tax Reform
Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085. Section 863(d) governs
the source of income derived from space or ocean activities. Section
863(e) governs the source of income derived from international
communications activities.
The Treasury Department and the IRS published a notice of proposed
rulemaking (REG-106030-98) in the Federal Register on January 17, 2001
(66 FR 3903), which provided proposed regulations under section 863(a),
(b), (d), and (e) (the 2001 proposed regulations). The Treasury
Department and the IRS received numerous written comments on the 2001
proposed regulations and held a public hearing on May 23, 2001. Since
that time, the aerospace, telecommunications, and related industries
have experienced substantial technological evolution and significant
business change and consolidation. In addition, the American Jobs
Creation Act of 2004 (AJCA), Pub. L. No. 108-357, 118 Stat. 1418,
enacted a number of materially relevant statutory changes that affect
the treatment of space and ocean income for purposes of the foreign tax
credit and subpart F rules.
In light of the extensive written comments, industry evolution, and
AJCA changes, the Treasury Department and the IRS felt that it was
appropriate to repropose these regulations to reflect these changes and
to provide another opportunity for comment. Consequently, the Treasury
Department and the IRS published another notice of proposed rulemaking
in the Federal Register on September 19, 2005 (70 FR 54859), which
withdrew the 2001 proposed regulations and provided new proposed
regulations under section 863(a), (b), (d), and (e) (the proposed
regulations). The proposed regulations provided two sets of rules: one
in Sec. 1.863-8 for determining the source of income from space or
ocean activities, the other in Sec. 1.863-9 for determining the source
of income from communications activities.
A public hearing on the proposed regulations was scheduled for
December 15, 2005, but was ultimately cancelled because no one
requested to speak. A few written comments, however, were received.
These comments uniformly praised the proposed regulations as an
improvement over the 2001 proposed regulations and generally were
supportive of much of the proposed regulations. However, commentators
suggested a few additional changes. After consideration of these
comments, the proposed regulations are adopted as final regulations, as
amended by this Treasury decision. The revisions to regulations
governing the source of income from space or ocean activities and the
source of income from communications activities are discussed in
section A and section B, respectively, of this preamble.
Summary of Comments and Explanation of Revisions
A. Space or Ocean Activity Under Section 863(d)
Section 863(d) governs the source of income from certain space or
ocean activities. In general, section 863(d)(1) provides that, except
as provided in regulations, any income derived from a space or ocean
activity (space and ocean income) is income from sources within the
United States (U.S. source income) if derived by a United States person
and is income from sources without the United States (foreign source
income) if derived by a foreign person. Section 863(d)(2)(A)(i) defines
space activity to include any activity conducted in space. Section
863(d)(2)(A)(ii) defines ocean activity to include any activity
conducted on or under water not within the jurisdiction (as recognized
by the United States) of a foreign country, possession of the United
States, or the United States. Section 863(d)(2)(B) excludes three types
of activities from the definition of space or ocean activity. Space or
ocean activity does not include any activity giving rise to
transportation income governed by section 863(c), international
communications income governed by section 863(e), or income with
respect to mines, oil and gas wells, or other natural deposits to the
extent within the United States or any foreign country or possession of
the United States (as defined in section 638). See Section
863(d)(2)(B).
Section 1.863-8 of the proposed regulations generally provided
rules for determining the source of income derived from space or ocean
activity under section 863(d). Section 1.863-8(b)(1) of the proposed
regulations reflected the general source rule under section 863(d)(1)
that a United States person's space and ocean income is U.S. source
income. Pursuant to the grant of regulatory authority under section
863(d)(1), however, the proposed regulations provided an exception to
this general rule. Under that exception, a United States person's space
and ocean income is foreign source income (and therefore not sourced on
the basis of citizenship or residency) to the extent the income, based
on all the facts and circumstances, is attributable to functions
performed, resources employed, or risks assumed in a foreign country or
countries.
For a foreign person, proposed Sec. 1.863-8(b)(2) reflected the
general source rule under section 863(d)(1) that a foreign person's
space and ocean income is foreign source income. Pursuant to regulatory
authority under section 863(d)(1), however, the proposed regulations
contained two exceptions to this general rule, one for controlled
foreign corporations (CFCs), the other for foreign persons engaged in a
U.S. trade or business. The proposed regulations generally sourced
space and ocean income derived by a CFC, like that of a United States
person, as U.S. source income. However, also like the rule for a United
States person, a CFC's space and ocean income is foreign source income
to the extent the income, based on all the facts and circumstances, is
attributable to functions performed, resources employed, or risks
assumed in a foreign country or countries. For a foreign person, other
than a CFC, engaged in a trade or business within the United
[[Page 77596]]
States, space and ocean income is U.S. source income to the extent it
is attributable to functions performed, resources employed, or risks
assumed within the United States.
In addition to the general source rules for United States and
foreign persons, the proposed regulations provided special rules,
applicable to both United States and foreign persons, for income from
services, certain sales of property, and communications activities
(other than international communications activities). These special
rules, as well as modifications to the proposed regulations, are
discussed below.
1. Activities performed outside space and international water
Section 1.863-8 of the proposed regulations provided source rules
only for income from space or ocean activity. Thus, in some cases,
income derived from a transaction must be allocated between space and
ocean income and other income.
For example, Sec. 1.863-8(b)(3)(ii)(C) of the proposed regulations
provided that when property is produced both in space or international
water and outside space and international water, gross income allocable
to production activity is allocated to production occurring in space or
international water and production occurring outside space and
international water based on where functions are performed, resources
are employed, or risks are assumed. The proposed regulations also
provided a similar analysis of functions performed, resources employed,
or risks assumed to allocate income in the case of performance of
services. See Prop. Treas. Reg. Sec. 1.863-8(d)(2). Under the proposed
regulations, only the amount allocated to production or performance of
a service occurring in space or international water is treated as space
and ocean income (character rule). The source of gross income allocated
to production or performance of a service occurring in space or
international water is then determined under the rules of proposed
Sec. 1.863-8(b)(1) or (2), as applicable (source rule).
Section 1.863-8(b)(1) of the proposed regulations reflected the
general source rule that a United States person's space and ocean
income is U.S. source income. Proposed Sec. 1.863-8(b)(2) reflected
the general source rule that a foreign person's space and ocean income
is foreign source income. Both proposed Sec. 1.863-8(b)(1) and (2),
however, provided exceptions to their respective general source rules.
As discussed above, under the exceptions, a United States person's
space and ocean income may be foreign source income and a foreign
person's space and ocean income may be U.S. source income based on
where functions are performed, resources are employed, or risks are
assumed.
One commentator noted that in some situations, the allocation of
income derived from a transaction to determine space and ocean income
based on functions performed, resources employed, or risks assumed
presumably would remove the subsequent need to further analyze
functions performed, resources employed, or risks assumed within a
country to determine the source of the space and ocean income. In other
words, the very act of determining the character of income seems to
also determine the source of such income.
The Treasury Department and the IRS agree with the commentator that
use of the same standard to classify the transaction as space or ocean
activity and to source the space and ocean income may be duplicative in
some cases. However, there are other cases where a transaction with
some land-based activity may be classified in its entirety as a space
or ocean activity (for example, a lease of a satellite), but the income
may be partially U.S. source and partially foreign source under the
source rules of proposed Sec. 1.863-8(b)(1) and (2) based on functions
performed, resources employed, or risks assumed within the United
States or a foreign country. Consequently, the character and source
rules are not always duplicative.
Thus, the extent to which the character rules overlap with the
source rules is particular to the type of transaction involved. The
Treasury Department and the IRS recognize that the overlap in the
character and source rules may produce equivalent results. But, the
overlap is necessary to provide taxpayers and the IRS with workable
rules. As a result, the final regulations do not follow this comment as
a general matter.
Nonetheless, a conforming amendment has been made to the lease
transaction in Example 1 in Sec. 1.863-8(f) of the final regulations
to more clearly illustrate how the rules work. That example illustrates
that the transaction involved is first classified in its entirety as a
space or ocean activity, and then the resulting space and ocean income
is subjected to the source rules. The space and ocean income is sourced
as foreign source income to the extent the income, based on all the
facts and circumstances, is attributable to functions performed,
resources employed, or risks assumed in a foreign country or countries.
2. Activities performed by another person
Section 1.863-8(a) of the proposed regulations provided that a
taxpayer will not be considered to derive income from space or ocean
activity if such activity is performed by another person. The approach
under Sec. 1.863-8(a) of the proposed regulations, providing that a
taxpayer derives income from a space or ocean activity only if it
conducts such activity directly, is consistent with the approach
adopted in the Sec. 1.863-3 regulations governing the source of income
from certain sales of inventory. See, e.g., Treas. Reg. Sec. 1.863-
3(c) (``[T]he only production activities that are taken into account
for purposes of Sec. Sec. 1.863-1, 1.863-2, and this section are those
conducted directly by the taxpayer.'').
Accordingly, commentators believed that this provision assured that
a content provider that retains a satellite operator to transmit
programming abroad would not derive space and ocean income based on
attribution of the satellite operator's activity. The Treasury
Department and the IRS agree.
One commentator noted, however, that Examples 2 and 4 in Sec.
1.863-8(f) of the proposed regulations seem to indicate that this is
not what was intended. In Example 2, the taxpayer, an Internet service
provider, transmits information requested by its customer, in part
using satellite capacity leased from a third party. Example 2 concludes
that the service performed by the taxpayer is considered space activity
to the extent the value of the service is attributable to functions
performed, resources employed, and risks assumed in space. In Example
4, the taxpayer uses satellite capacity acquired from a third party to
deliver programming services directly to its customers' televisions
sets. Example 4 concludes that the taxpayer's delivery of programming
and other services is considered space activity to the extent the value
of the delivery transaction is attributable to performance in space. In
the commentator's view, the results reached in the examples conflict
with the provision stating that activities performed by another person
are not attributable to the taxpayer.
The Treasury Department and the IRS do not believe that Examples 2
and 4 of Sec. 1.863-8(f) of the proposed regulations produce the
result that the commentator raised. In Examples 2 and 4, the taxpayer
performed the transmission or delivery activities using satellite
capacity leased or acquired from a third party. Both Examples 2 and 4
correctly conclude that the taxpayers derived space and ocean income
from their own
[[Page 77597]]
activities rather than from activities of another person. Thus, the
examples do not, in fact, conflict with the text of the proposed
regulations. Nevertheless, the Treasury Department and the IRS are
concerned that Examples 2 and 4 have been misinterpreted as suggesting
that activities performed by another person may be attributable to the
taxpayer in certain situations. This was not the intent of these
examples. Consequently, Examples 2 and 4 in Sec. 1.863-8(f) of the
final regulations have been modified to make clear that the taxpayers
in the examples directly engage in a space activity by performing the
uplink (transmitting to the satellite) and downlink functions.
These examples differ from cases in which the taxpayer is a mere
content provider that derives income either from the creation of
content or from the creation and delivery of content, but in either
case contracts with another person to deliver the content via
satellite. Pursuant to Sec. 1.863-8(a) of the final regulations,
content providers of this type would not derive space and ocean income
because the delivery of the content via satellite is performed by
another person. This would be the result even though the value of the
customer contract includes a payment to the content provider for space
or ocean activity. To clarify the distinction between these situations
and Examples 2 and 4, a new Example 5 has been added to the final
regulations. That example involves a content provider that does not
derive space and ocean income because the taxpayer does not directly
perform any space or ocean activity.
3. Income Characterization Rules for Income from Services and the De
Minimis Exception
Under Sec. 1.863-8(b)(4) of the proposed regulations, to the
extent a service is characterized as space or ocean activity, the
source of gross income derived from such transaction is determined
under proposed Sec. 1.863-8(b)(1) or (2), as applicable. Section
1.863-8(d)(2)(ii)(B) of the proposed regulations provided, however,
that if the taxpayer can demonstrate, based on all the facts and
circumstances, that the value of the service attributable to
performance in space or international water is de minimis, such service
will not be treated as space or ocean activity. The de minimis rule was
adopted to address taxpayers' concerns about potential confusion in
qualifying for the ``facilitation exception'' under the 2001 proposed
regulations. One commentator stated that the de minimis rule simply
replaced one vague standard with another, as neither Example 3 in Sec.
1.863-8(f) of the proposed regulations nor the text of the proposed
regulations provides any guidance as to when activities performed in
space or international water would be de minimis under a facts and
circumstances approach.
The Treasury Department and the IRS recognize that issues of
interpretation may arise in any facts and circumstances approach.
Nevertheless, the Treasury Department and the IRS generally have
refrained from adopting the alternative approach, to wit, adopting
precise definitions and quantitative measures for a de minimis
standard. Moreover, the inclusion of a precise definition and
quantitative measures for determining de minimis value could raise
equal, if not greater, concerns in terms of the quantitative threshold
and other issues. Thus, the final regulations retain the de minimis
standard for determining whether a taxpayer has space and ocean income.
If the value of the service attributable to space or ocean activity is
de minimis based on the facts and circumstances, the taxpayer will not
derive space and ocean income. Nevertheless, the Treasury Department
and the IRS agree that more guidance could be provided as to the
application of the retained de minimis rule. Accordingly, Examples 3
and 8 in Sec. 1.863-8(f) of the final regulations (Example 7 in the
proposed regulations) provide clearer illustrations of when activities
performed in space or international water would be considered de
minimis for this purpose and when those types of activities would not
be considered de minimis.
4. Source Rules for Income From Certain Sales of Property
The proposed regulations provided special rules for income from
certain sales of property, either when any production occurs in space
or international water, or when the sale occurs in space or
international water. In either case, section 863(d) and the proposed
regulations applied to determine the source of income from the sales of
property, and the rules of sections 861(a)(6), 862(a)(6), 863(a),
863(b), and 865 apply only to the extent provided in the proposed
regulations.
a. Sales of Property Produced in the United States and Sold in Space or
International Water
Section 1.863-8(b)(3)(ii) of the proposed regulations provided that
when the taxpayer both produces property and sells such property, one-
half of the taxpayer's gross income will be considered income allocable
to production activity and one-half of such gross income will be
considered income allocable to sales activity. Taxpayers generally must
then apply the rules of section 863(d) and the proposed regulations to
determine the source of income allocable to production activity and
sales activity.
For production activity, the source of gross income allocable to
production occurring in space or international water is generally based
on the citizenship or residence of the taxpayer, applying the rules of
proposed Sec. 1.863-8(b)(1) or (2), as applicable. The source of gross
income allocable to production occurring outside space and
international water is determined under section 863(b) rather than
section 863(d). See Prop. Treas. Reg. Sec. 1.863-8(b)(3)(ii)(B)
(referencing Treas. Reg. Sec. 1.863-3(c)(1)).
As for sales activity, when property is sold in space or
international water, the source of gross income allocable to sales
activity is generally based on the citizenship or residence of the
taxpayer, applying the rules of proposed Sec. 1.863-8(b)(1) or (2), as
applicable. An exception to this general rule applied in cases when the
property sold is inventory, within the meaning of section 1221(a)(1),
and is sold in space or international water for use, consumption, or
disposition outside space, international water, and the United States.
In that case, the source of gross income allocable to sales activity is
determined under Treas. Reg. Sec. 1.861-7(c) and Sec. 1.863-3(c)(2).
Treas. Reg. Sec. 1.861-7(c) and Sec. 1.863-3(c)(2) generally provide
for foreign source income where the seller's rights, title, and
interest in the property are transferred to the buyer (the title
passage rule) outside the United States and the property is not sold
for use, consumption, or disposition in the United States. Treas. Reg.
Sec. 1.861-7(c) and Sec. 1.863-3(c)(2) also applied to property sold
outside space and international water. See Prop. Treas. Reg. Sec.
1.863-8(b)(3)(ii)(D).
One commentator believed that because certain U.S. manufacturers,
such as U.S. satellite manufacturers, produce property that is sold in
space or international water for use, consumption, or disposition in
space or international water, they are at a disadvantage relative to
U.S. manufacturers of other export property because the former may have
U.S. source income with respect to income allocable to sales activity,
while the latter may have foreign source income from sales activity.
In response to comments on the 2001 proposed regulations, proposed
Sec. 1.863-
[[Page 77598]]
8(b)(1) was revised to provide that space and ocean income will be
foreign source income to the extent the space and ocean income is
attributable to functions performed, resources employed, or risks
assumed in a foreign country or countries. The Treasury Department and
the IRS believe that this change may in many cases mitigate concerns
about U.S. manufacturers potentially deriving 100 percent U.S. source
income in these cases. Moreover, the Treasury Department and the IRS
believe that the rules under the proposed regulations for determining
the source of income allocable to sales activity are consistent with
legislative intent to assert primary tax jurisdiction over income
earned by United States persons that is not subject to foreign tax. See
S. REP. NO. 99-313, 1986-3 C.B. 357-358 (``[T]he committee believes the
United States should assert primary tax jurisdiction over income earned
by its residents that is not within any foreign country's taxing
jurisdiction* * *. Moreover, when a U.S. taxpayer conducts activities
in space or international waters, foreign countries generally do not
tax the income. Thus, the foreign tax credit limitation is inflated by
income that is not within any foreign country's tax jurisdiction.'').
Based on the legislative history, the Treasury Department and the IRS
believe that sales of property in space or international water--with
the exception of sales of inventory property in space or international
water for use, consumption, or disposition outside space, international
water, and the United States--should be considered space or ocean
activity and that the source of income from such sales activity should
be determined under section 863(d). As a result, no changes were made
in response to this comment.
b. Purchased Versus Produced Property Sold for Use, Consumption, or
Disposition in the United States
One commentator questioned the appropriateness of differences in
determining the source of sales income depending on whether the
taxpayer produced or purchased the property sold. Under the proposed
regulations, when property produced by the taxpayer is sold in space or
international water, the source of gross income allocable to sales
activity is generally based on the citizenship or residence of the
taxpayer, applying the rules of proposed Sec. 1.863-8(b)(1) or (2), as
applicable (and not the title passage rule)--subject to the foregoing
inventory exception for property that will be used, consumed, or
disposed of outside space, international water, and the United States.
A slightly different rule applied to sales of property that had been
purchased by the taxpayer. While the proposed regulations also provided
that, for purchased property, the source of gross income allocable to
sales activity is generally based on the citizenship or residence of
the taxpayer, the inventory exception for purchased property only
required that the property be used, consumed, or disposed of outside
space and international water.
The inventory exceptions for produced and purchased property were
intended to produce different results when inventory property is used,
consumed, or disposed of in the United States. In such case, the source
of produced inventory property sales income is generally based on the
citizenship or residence of the taxpayer, applying the rules of
proposed Sec. 1.863-8(b)(1) or (2), because the inventory exception
did not extend to produced property sold for use, consumption, or
disposition in the United States. In contrast, the source of purchased
inventory property sales income is generally based on title passage
under Treas. Reg. Sec. 1.861-7(c) because the inventory exception did
extend to purchased property even if it was sold for use, consumption,
or disposition in the United States. The Treasury Department and the
IRS believe that this difference between the produced and purchased
property rules in the space and ocean context is consistent with the
difference in the rules for sales of produced and purchased property
outside the space and ocean context. In particular, under section
863(a) and (b) and the regulations thereunder, if property is produced
in the United States and sold for use, consumption, or disposition in
the United States, the place of sale will be presumed to be the United
States, and income attributable to the sales activity will be U.S.
source income. See Sec. 1.863-3(c)(2). There is, however, no
comparable rule for purchased property under section 862(a)(6) or the
regulations thereunder. Thus, the final regulations simply continue in
the space and ocean context the varying treatment elsewhere for sales
of purchased property and sales of produced property.
In response to comments, however, the produced and purchased
property rules have been modified to be similar in structure and style,
to better reflect and highlight the differences between these two
rules.
5. Allocations
Taxpayers must allocate gross income under paragraphs (b)(1) and
(b)(2) of proposed Sec. 1.863-8 among U.S., foreign, and space or
ocean activities. Under proposed Sec. 1.863-8(b)(3)(ii)(C),
allocations are also made between production activity occurring in
space or international water and that occurring outside space and
international water. Finally, allocations are also made under proposed
Sec. 1.863-8(b)(4) between services performed in space or
international water and services performed outside space and
international water. In performing these allocations, the proposed
regulations generally provided that taxpayers should consider the
relative value of functions performed, resources employed, or risks
assumed in different locations. Moreover, the preamble to the proposed
regulations provided that allocations should be based generally on
section 482 principles. Commentators noted that little guidance is
given as to the mechanics of allocation other than the statement that
the principles of section 482 should be used. Commentators stated that
allocation of gross income based on section 482 principles will result
in added expense, uncertainty, and extra burden on multinational
taxpayers who are already required to undertake and update functional
analyses and satisfy substantial documentation requirements.
While the final regulations were not changed in response to these
comments, the Treasury Department and the IRS believe that some
clarification is warranted. In suggesting the use of section 482
principles as a guide, the Treasury Department and the IRS intend for
taxpayers to adopt a reasonable approach to the allocations required in
this area. Taxpayers know their businesses and will generally be in the
best position to fashion a reasonable method that most reliably
reflects the relative value of functions performed, resources employed,
and risks assumed in different locations. In the preamble to the
proposed regulations, the Treasury Department and the IRS solicited
comments on alternative methods of allocation for particular industries
and criteria that could be used to evaluate the reasonableness of such
methods. No such comments were received. One commentator noted,
however, that the proposed regulations perhaps reflected what taxpayers
in these industries have already been doing in order to determine the
character and source of their space and ocean income. Consequently, the
Treasury Department and the IRS believe that allocations of gross
income based on functions performed, resources employed, and
[[Page 77599]]
risks assumed are appropriate in these circumstances.
6. Separation of a Single Transaction and Aggregation of Multiple
Transactions
Paragraphs (d)(1)(i) and (d)(1)(ii) of Sec. 1.863-8 of the
proposed regulations provided that for purposes of determining space or
ocean activity, the Commissioner may separate parts of a single
transaction or combine separate transactions into a single transaction.
One commentator stated that this is a ``one-way'' street, as only the
Commissioner has the authority to separate or combine transactions for
purposes of the proposed regulations.
The final regulations do not change this rule. The Treasury
Department and the IRS believe taxpayers are not inappropriately
disadvantaged by this rule because taxpayers generally have the ability
to structure their transactions in line with the economic prospects of
their businesses. In addition, the Commissioner's ability to separate
or combine transactions is not unfettered. Rather, the Commissioner may
only separate or combine transactions to better reflect the value of
functions performed, resources employed, or risks assumed. A taxpayer
can always protect itself against recharacterization by adopting an
arrangement that appropriately reflects the economic realities of a
transaction or series of transactions. The taxpayer is clearly in the
best position at the outset to structure its arrangements in this
manner. In addition, taxpayers traditionally are not permitted to
restructure retroactively the form of their completed transactions.
Thus, the Treasury Department and the IRS believe that the limited
``one-way'' rule is appropriate in this case.
7. Income Derived From the Leasing of Shipping Cargo Containers
One commentator requested that the Treasury Department and the IRS
make clear that the final regulations under section 863(d) do not apply
to income derived from the leasing of shipping cargo containers and
that such income should be treated as rental income, sourced under
sections 861 and 862. This commentator noted that valid arguments also
exist for treating income derived from the leasing of shipping cargo
containers as transportation income; however, in the commentator's
view, the most appropriate treatment is rental income treatment,
sourced under sections 861 and 862.
The treatment of income derived from the leasing of shipping cargo
containers is not covered by these final regulations. Instead, the
Treasury Department and the IRS intend to address the treatment of such
income explicitly in separate guidance. That guidance may apply section
863(c), section 863(d), or other provisions to source income derived
from the leasing of shipping cargo containers. Any such guidance will
be prospective in nature. Until such time, the treatment of such income
will be determined under existing law.
B. Communications Activity Under Section 863(a), (d), and (e)
Section 863(e) governs the source of income from international
communications activities (international communications income).
International communications income is defined in section 863(e)(2) as
income derived from the transmission of communications or data between
the United States and a foreign country (or possession of the United
States). Section 863(e)(1)(A) provides that any international
communications income of a United States person is sourced 50 percent
in the United States and 50 percent outside the United States (50/50
source rule). Section 863(e)(1)(A) does not provide for any statutory
or regulatory exceptions to this 50/50 source rule. In contrast,
section 863(e)(1)(B)(i) provides that any international communications
income of a foreign person is sourced outside the United States, except
as provided in regulations or in section 863(e)(1)(B)(ii). The
exception under section 863(e)(1)(B)(ii) provides that if a foreign
person maintains an office or other fixed place of business in the
United States, any international communications income attributable to
such office or other fixed place of business is U.S. source income.
Section 1.863-9 of the proposed regulations generally provided
rules for determining the source of international communications income
under section 863(e) and other communications income under section
863(a) and (d). Proposed Sec. 1.863-9(b)(1) reflected the rule under
section 863(e)(1)(A) that a United States person's international
communications income is 50 percent U.S. source income and 50 percent
foreign source income. Proposed Sec. 1.863-9(b)(2) reflected the
general rule under section 863(e)(1)(B) that a foreign person's
international communications income is foreign source income.
Consistent with the statutory exception under section
863(e)(1)(B)(ii), proposed Sec. 1.863-9(b)(2)(iii) provided that any
international communications income derived by a foreign person, other
than a CFC, that is attributable to an office or other fixed place of
business of the foreign person in the United States is U.S. source
income. International communications income is attributable to an
office or other fixed place of business to the extent of functions
performed, resources employed, or risks assumed by the office or other
fixed place of business. In addition to the statutory exception under
section 863(e)(1)(B)(ii), section 863(e)(1)(B) provides general
regulatory authority to depart from the general 100 percent foreign
source rule for foreign persons. Thus, pursuant to this regulatory
authority, the proposed regulations contained additional exceptions to
the general rule applicable to foreign persons. In particular, the
proposed regulations provided that international communications income
derived by a CFC is 50 percent U.S. source income and 50 percent
foreign source income (the same as for United States persons). The
proposed regulations also provided that international communications
income derived by a foreign person, other than a CFC, engaged in a
trade or business within the United States is income from sources
within the United States to the extent the income, based on all the
facts and circumstances, is attributable to functions performed,
resources employed, or risks assumed within the United States.
In addition to the general source rules for international
communications income of United States and foreign persons, the
proposed regulations also provided rules, applicable to both United
States and foreign persons, for income from U.S. communications,
foreign communications, space/ocean communications, and communications
where endpoints are indeterminate. These rules, as well as
modifications to the proposed regulations, are discussed below.
1. Income Characterization Rules for Communications Income
Section 1.863-9(h)(3) of the proposed regulations provided that the
type of communications activity (and thus the applicable source rule)
is determined by identifying the two points between which the taxpayer
is paid to transmit the communication. For United States and foreign
persons, U.S. communications income is entirely U.S. source income. A
taxpayer derives U.S. communications income when the taxpayer is paid
to transmit between two points in the United States or between the
United States and a point in space or international water. In contrast,
foreign communications income is entirely foreign source income for
United States and foreign
[[Page 77600]]
persons. A taxpayer derives foreign communications income when the
taxpayer is paid to transmit between two points in a foreign country or
countries (or a possession or possessions of the United States),
between a foreign country and a possession of the United States, or
between a foreign country (or a possession of the United States) and a
point in space or international water. Finally, the proposed
regulations provided different source rules for international
communications income of United States and foreign persons. See section
B.3 of this preamble for further discussion. A taxpayer derives
international communications income when the taxpayer is paid to
transmit between a point in the United States and a point in a foreign
country (or a possession of the United States). When a taxpayer cannot
establish the two points between which the taxpayer is paid to transmit
the communication, Sec. 1.863-9(f) of the proposed regulation provided
a default source rule under which all the income derived by the
taxpayer from such communications activity is U.S. source income.
Commentators stated that the treatment of communications income as
U.S. source income when the endpoints are indeterminate is overbroad
and harsh, particularly as it relates to foreign taxpayers.
Commentators also stated that taxpayers would have to commit
significant resources to develop the technology necessary to identify
the endpoints of communications. One commentator stated that it is
unclear that a reliable system can be created at any expense to
establish the endpoints of the transmission under all circumstances.
Commentators suggested instead the use of any reasonable method to
establish the endpoints between which a taxpayer is paid to transmit
the communications. One commentator suggested that the Treasury
Department and the IRS consider employing the Industry Issue Resolution
Program or Prefiling Agreement Program as aids in the administration of
a reasonable method rule.
The Treasury Department and the IRS solicited comments on the
challenges to identifying the endpoints of communications in specific
industries or situations, as well as suggestions for rules that are
responsive to these particular challenges. The Treasury Department and
the IRS also solicited comments on methods to establish the endpoints
of a communication that may be reasonable for particular industries, as
well as criteria that may be appropriate to evaluate the reasonableness
of such methods. In response, one commentator submitted examples of
reasonable methods to establish the endpoints between which a taxpayer
is paid to transmit the communications. The examples relied on
statistical reports of data such as minutes used, areas of
transmission, port locations, and transport charges. This commentator
noted that current federal regulations already require
telecommunications companies to submit some of these reports to certain
governmental agencies, for example, the Federal Communications
Commission.
In light of the potential complexity in identifying the type of
communications activity and in response to comments, the final
regulations provide that a taxpayer may satisfy the requirement that
the taxpayer establish the two points between which the taxpayer is
paid to transmit, and bears the risk of transmitting, the communication
by using any consistently applied reasonable method to establish one or
both endpoints. In doing so, the taxpayer carries the burden of proof
and must establish that the method used is reasonable (taking into
account all of the facts and circumstances) and is consistently
applied. In satisfying its burden of proof, a taxpayer will need to
maintain reasonable records of communications activities. Depending on
the facts and circumstances, methods based on, for example, records of
port or transport charges, customer billing records, a satellite
footprint, or records of termination fees made pursuant to an
international settlement agreement may be reasonable. In addition,
practices used by taxpayers to classify or categorize certain
communications activity in connection with preparation of statements
and analyses for the use of management, creditors, minority
shareholders, joint ventures, or other parties or governmental agencies
in interest may be reliable indicators of the reasonableness of the
method chosen, but need not be accorded conclusive weight by the
Commissioner. Furthermore, in evaluating the reasonableness of the
method chosen, consideration will be given to all the facts and
circumstances, including whether the endpoints would otherwise be
identifiable absent this reasonable method provision.
Along with resultant changes made to the text of the final
regulations, several examples have been added to Sec. 1.863-9(j) of
the final regulations that illustrate instances where the taxpayer may
be able to use reasonable methods to determine the endpoints between
which the taxpayer is paid to transmit the communications.
2. The Paid-to-do Rule With Respect to Foreign-Originating
Communications
Under the proposed regulations, a taxpayer derives income from a
certain type of communications activity (for example, foreign
communications or international communications) only if the taxpayer is
paid to transmit, and bears the risk of transmitting (the paid-to-do
rule), the communications of such type. See Prop. Treas. Reg. Sec.
1.863-9(h)(2) and (3). This is the case even if the taxpayer contracts
out the transmission function.
Commentators stated that application of the paid-to-do rule in all
instances would give rise to results that are inconsistent with
Congressional intent and may result in excessive amounts of U.S. source
income. One commentator noted that in some cases, while it is clear
that a communication originated in a foreign country and that a U.S.
telecommunications company is paid to terminate the foreign-originating
traffic in the United States, it is unclear exactly where the U.S.
telecommunications company picked up the communication. This lack of
clarity often may be due to legal restrictions in certain foreign
countries on ownership of capacity and carriage of transmissions by
non-nationals. It can also be due to the fact that the international
settlement agreements under which major international
telecommunications carriers operate often do not specify where the
traffic is picked up or handed off, and in some cases the hand-off
point is specified by reference to a mid-point convention, even though
the transmission signal, from a technical standpoint, travels from end-
to-end with no real points in-between. The commentator further stated
that at the time section 863(e) was enacted, U.S. carriers were
generally not allowed to own and operate facilities in foreign
countries; specifically, no U.S. carrier could carry a foreign-to-U.S.
or U.S.-to-foreign transmission end-to-end. Thus, concluded the
commentator, Congress focused on the endpoints of the communications
rather than where the activities constituting the transmission of
communications take place. The commentator suggested a rule that would
provide that when a taxpayer is paid to transmit foreign-originating
communications from a point outside the United States to a point in the
United States, the taxpayer should be deemed to have been paid to
transmit the communications from a point in the foreign country in
which the communication originated.
Upon further consideration, the Treasury Department and the IRS
[[Page 77601]]
believe that the paid-to-do rule may be over-inclusive in certain
cases. Accordingly, the final regulations provide that international
communications income also includes income derived from communications
activity when the taxpayer is paid to transmit foreign-originating
communications (communications with a beginning point in a foreign
country or a possession of the United States) from a point in space or
international water to a point in the United States. Also, a new
example has been added to Sec. 1.863-9(j) of the final regulations to
illustrate the changes made in the final regulations with respect to
foreign-originating communications.
The changes made in the final regulations only affect
communications that originate in a foreign country (or a possession of
the United States) and does not affect communications that originate in
space, international water, or the United States. The Treasury
Department and the IRS continue to believe that communications activity
is most appropriately characterized based on the two points between
which the taxpayer is paid to transmit, and bears the risk of
transmitting, the communication.
3. Determining the Source of Communications Income Based on Functions
Performed, Resources Employed, or Risks Assumed in a Foreign Country or
Countries
As discussed above, the proposed regulations provided that the
source of communications income is largely dependant on the type of
communications activity and the citizenship or residence of the
taxpayer. However, the proposed regulations provided for two instances
where (in addition to the type of communications activity and the
citizenship or residence of the taxpayer) the source of communications
income may depend on functions performed, resources employed, or risks
assumed. First, the proposed regulations provided that international
communications income derived by a foreign person, other than a CFC,
that is attributable to an office or other fixed place of business of
the foreign person in the United States is U.S. source income. The
proposed regulations provided that international communications income
is attributable to an office or other fixed place of business to the
extent of functions performed, resources employed, or risks assumed by
the office or other fixed place of business. Second, the proposed
regulations provided that international communications income derived
by a foreign person, other than a CFC, engaged in a trade or business
within the United States is income from sources within the United
States to the extent the income, based on all the facts and
circumstances, is attributable to functions performed, resources
employed, or risks assumed within the United States.
Commentators suggested that the final regulations also provide for
similar rules that would source communications income as foreign source
income based on functions performed, resources employed, or risks
assumed in a foreign country or countries. For example, one commentator
suggested that the source of international and U.S. communications
income derived by any United States or foreign person (including
branches, partnerships, and disregarded entities) engaged in a trade or
business in a foreign country or countries is income from sources
without the United States to the extent the income, based on all the
facts and circumstances, is attributable to functions performed,
resources employed, or risks assumed in such foreign country or
countries.
While the Treasury Department and the IRS recognize that
commentators' suggestion to provide for a source rule based on
functions performed, resources employed, or risks assumed in a foreign
country or countries is reasonable, as explained below, the Treasury
Department and the IRS believe that the statute and legislative history
preclude such an option.
a. International Communications Income
Consistent with section 863(e)(1)(A), proposed Sec. 1.863-9(b)(1)
provided that international communications income of a United States
person is 50 percent U.S. source income and 50 percent foreign source
income. One commentator suggested that it may be appropriate, in
certain situations, to depart from the 50/50 source rule to provide
special rules for foreign activities. According to the commentator, as
a result of local regulatory requirements, U.S.-based international
telecommunications providers often need to conduct portions of their
international business through locally formed entities, and such
entities are fully subject to foreign tax on their income. The
commentator therefore concluded that a source rule for international
communications income based on functions performed, resources employed,
or risks assumed in a foreign country or countries is not only
equitable but also consistent with treatment accorded to foreign
persons having a U.S. fixed placed of business or engaged in a U.S.
trade or business.
The Treasury Department and the IRS recognize that a source rule
based on functions performed, resources employed, or risks assumed may
be a reasonable alternative to the 50/50 source rule. Nonetheless, they
continue to believe that the 50/50 source rule is the method that must
be used to determine the source of a United States person's
international communications income. This is because section
863(e)(1)(A) provides for an explicit 50/50 source rule for those
persons without exception. In contrast, section 863(e)(1)(B) provides
that a foreign person's international communications income is
generally sourced outside the United States, except as provided in
regulations. The Treasury Department and the IRS believe that the
express grant of regulatory authority in the case of foreign persons
and the omission of any such authority in the case of United States
persons indicate that Congress intended the 50/50 sourcing rule be
applied to United States persons without regulatory modification. There
is nothing in the statute or legislative history that clearly
demonstrates a different intention. In contrast, section
863(e)(1)(B)(ii) provides for a special source rule with respect to
foreign persons with an office or other fixed place of business in the
United States. A similar rule is not provided with respect to a United
States person's foreign activities. Thus, Congress chose a rule that
sourced international communications income of foreign persons in
certain instances based on the place of their activities, but expressly
chose the 50/50 method to source international communications income of
United States persons, regardless of the place of their activities.
The Treasury Department and the IRS recognize that the statute does
not require strict application of the 50/50 source rule for CFCs.
Section 863(e)(1)(B) only provides that the international
communications income of a foreign person is foreign source income,
except as provided in regulations. Consistent with and in light of this
regulatory authority, however, the Treasury Department and the IRS
believe that the 50/50 source rule is the most appropriate method to
determine the source of a CFC's international communications income.
This approach addresses the concern of the Treasury Department and the
IRS that United States persons may use CFCs to obtain benefits that are
inconsistent with the purposes of section 863(e). Consequently, the
rules for determining the source of international
[[Page 77602]]
communications income derived by a CFC should be the same as the rules
for determining the source of such income if it is derived by a United
States person. In addition, the Treasury Department and the IRS believe
that the 50/50 source rule for CFCs, as opposed to the 100 percent U.S.
source rule that was originally proposed as part of the 2001 proposed
regulations, should limit the potential for multiple levels of taxation
that commentators raised with respect to those prior proposed
regulations.
b. U.S. Communications Income
Section 1.863-9(c) of the proposed regulations provided that income
derived by a United States or foreign person from U.S. communications
activity is entirely from sources within the United States. One
commentator noted that a foreign person deriving income from the
transmission of communications between a point in the United States and
another point in the United States or between a point in the United
States and a point in space or international water has 100 percent U.S.
source income, even if much or all of the activity involved is outside
the United States. In contrast, under the space and ocean rules, a
foreign person has U.S. source income only to the extent the income is
attributable to functions performed, resources employed, or risks
assumed within the United States. Commentators therefore suggested
modification of the 100 percent U.S. source rule for U.S.
communications income derived by United States and foreign persons to
take into account foreign activities.
The Treasury Department and the IRS recognize that a source rule
based on functions performed, resources employed, or risks assumed may
be a reasonable alternative to the 100 percent U.S. source rule for
U.S. communications. Nonetheless, the Treasury Department and the IRS
believe that Congress did not intend such an option. The legislative
history indicates that if a communication is between two points within
the United States, the ``income attributable thereto is to be sourced
entirely as U.S. source income.'' S. Rep. No. 99-313, 1986-3 C.B. 359
(emphasis added). Congress intended such a result ``even if the
communication is routed through a satellite located in space,
regardless of the satellite's location.'' Id. Thus, the legislative
history clearly provides that Congress intended that U.S.
communications income be sourced entirely as U.S. source income.
4. International Communications Income Derived by a Foreign Person
(Other Than a CFC)
Proposed Sec. 1.863-9(b)(2) reflected the general rule under
section 863(e)(1)(B) that a foreign person's international
communications income is foreign source income. Consistent with the
statutory exception under section 863(e)(1)(B)(ii), proposed Sec.
1.863-9(b)(2)(iii) provided that any international communications
income derived by a foreign person, other than a CFC, that is
attributable to an office or other fixed place of business of the
foreign person in the United States is U.S. source income.
International communications income is attributable to an office or
other fixed place of business to the extent of functions performed,
resources employed, or risks assumed by the office or other fixed place
of business. Pursuant to the grant of regulatory authority under
section 863(e)(1)(B), the proposed regulations provided other
exceptions to the general rule for foreign persons. The first exception
is the 50/50 source rule for CFCs under Sec. 1.863-9(b)(2)(ii) of the
proposed regulations, as discussed above. The second exception was
provided in Sec. 1.863-9(b)(2)(iv) of the proposed regulations and
applied to foreign persons other than CFCs. Section 1.863-9(b)(2)(iv)
of the proposed regulations provided that international communications
income derived by a foreign person, other than a CFC, engaged in a
trade or business within the United States, that is attributable to
functions performed, resources employed, or risks assumed within the
United States is U.S. source income. One commentator noted that it is
unclear why a separate rule is needed for a fixed place of business in
the United States and a U.S. trade or business because international
communications income attributable to a fixed place of business in the
United States should also be attributable to functions performed,
resources employed and risks assumed within the United States.
As indicated, the office or other fixed place of business rule
under Sec. 1.863-9(b)(2)(iii) of the proposed regulations was derived
from the statutory language of section 863(e), while the trade or
business rule under Sec. 1.863-9(b)(2)(iv) of the proposed regulations
was derived from the express grant of regulatory authority to source
international communications income of foreign persons as other than
foreign source. The Treasury Department and the IRS recognize that in
most situations, the latter trade or business rule would indeed subsume
the former fixed place of business rule, but still believe that the
later rule serves an important function. The trade or business rule
addresses the concern of the Treasury Department and the IRS that a
foreign person could avoid a U.S. fixed place of business under section
863(e)(1)(B)(ii), yet engage in significant communications activity in
the United States. The Treasury Department and the IRS believe that
Congress intended that a foreign person engaged in substantial business
in the United States be subject to U.S. tax on that communications
activity.
5. Allocations
Section 1.863-9(h)(1)(ii) of the proposed regulations provided that
to the extent that a taxpayer's transaction consists in part of non-de
minimis communications activity and in part of non-de minimis non-
communications activity, each part of the transaction must be treated
as a separate transaction. Gross income is then allocated to each
communications activity transaction and each non-communications
activity transaction to the extent the income, based on all the facts
and circumstances, is attributable to functions performed, resources
employed, or risks assumed in each such activity. Moreover, the
Treasury Department and the IRS suggested in the preamble to the
proposed regulations that allocations of gross income should be based
generally on section 482 principles. One commentator stated that the
complexities inherent in allocating income, based on section 482
principles, between the separated transactions are significant.
While the final regulations were not changed in response to this
comment, as in the case of allocations for space and ocean income, the
Treasury Department and the IRS believe that some clarification is
warranted. In suggesting the use of section 482 principles as a guide,
the Treasury Department and the IRS intend for taxpayers to adopt a
reasonable approach to the allocations required in this area. Taxpayers
know their businesses and will generally be in the best position to
fashion a reasonable method that most reliably reflects the relative
value of functions performed, resources employed, and risks assumed in
different locations. In the preamble to the proposed regulations, the
Treasury Department and the IRS solicited comments on alternative
methods of allocation for particular industries and criteria that could
be used to evaluate the reasonableness of such methods. No such
comments were received. One commentator noted, however, that the
proposed regulations perhaps reflected
[[Page 77603]]
what taxpayers in these industries have already been doing in order to
determine the character and source of their communications income.
Consequently, as in the case of space and ocean income, the Treasury
Department and the IRS believe that allocations of gross income based
on functions performed, resources employed, and risks assumed are
appropriate in these circumstances.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment pursuant to that Order is not
required. It has also been determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to
these regulations. Pursuant to the Regulatory Flexibility Act (5 U.S.C.
chapter 6), it is hereby certified that the collection of information
in these regulations will not have a significant economic impact on a
substantial number of small entities. This certification is based on
the fact that the rules provided in these regulations principally
affect large multinational corporations that pay foreign taxes on
income derived from substantial foreign operations and that use these
and any other applicable source rules in determining their foreign tax
credit. Accordingly, a Regulatory Flexibility Act assessment is not
required. Pursuant to section 7805(f) of the Internal Revenue Code, the
NPRM preceding these regulations were submitted to the Chief Counsel
for Advocacy of the Small Business Administration for comment on their
impact on small business.
Drafting Information
The principal author of these regulations is H. Michael Huynh of
the Office of the Associate Chief Counsel (International). However,
other personnel from the Treasury Department and the IRS participated
in their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * *.
Section 1.863-8 also issued under 26 U.S.C. 863(a), (b) and (d).
* * *
Section 1.863-9 also issued under 26 U.S.C. 863(a), (d) and (e).
* * *
0
Par. 2. Section 1.863-3 is amended by:
0
1. Adding a sentence after the first sentence in paragraph (a)(1).
0
2. Adding a sentence at the end of paragraph (c)(1)(i)(A).
0
3. Adding a sentence after the first sentence in paragraph (c)(2).
The additions read as follows:
Sec. 1.863-3 Allocation and apportionment of income from certain
sales of inventory.
(a) * * *
(1) * * * To determine the source of income from sales of property
produced by the taxpayer, when the property is either produced in whole
or in part in space or on or under water not within the jurisdiction
(as recognized by the United States) of a foreign country, possession
of the United States, or the United States (in international water), or
is sold in space or international water, the rules of Sec. 1.863-8
apply, and the rules of this section do not apply except to the extent
provided in Sec. 1.863-8. * * *
(c) * * *
(1) * * *
(i) * * *
(A) * * * For rules regarding the source of income when production
takes place, in whole or in part, in space or international water, the
rules of Sec. 1.863-8 apply, and the rules of this section do not
apply except to the extent provided in Sec. 1.863-8.
* * * * *
(2) * * * Notwithstanding any other provision, for rules regarding
the source of income when a sale takes place in space or international
water, the rules of Sec. 1.863-8 apply, and the rules of this section
do not apply except to the extent provided in Sec. 1.863-8. * * *
* * * * *
0
Par. 3. Sections 1.863-8 and 1.863-9 are added to read as follows:
Sec. 1.863-8 Source of income derived from space and ocean activity
under section 863(d).
(a) In general. Income of a United States or a foreign person
derived from space and ocean activity (space and ocean income) is
sourced under the rules of this section, notwithstanding any other
provision, including sections 861, 862, 863, and 865. A taxpayer will
not be considered to derive income from space or ocean activity, as
defined in paragraph (d) of this section, if such activity is performed
by another person, subject to the rules for the treatment of
consolidated groups in Sec. 1.1502-13.
(b) Source of gross income from space and ocean activity--(1) Space
and ocean income derived by a United States person. Space and ocean
income derived by a United States person is income from sources within
the United States. However, space and ocean income derived by a United
States person is income from sources without the United States to the
extent the income, based on all the facts and circumstances, is
attributable to functions performed, resources employed, or risks
assumed in a foreign country or countries.
(2) Space and ocean income derived by a foreign person--(i) In
general. Space and ocean income derived by a person other than a United
States person is income from sources without the United States, except
as otherwise provided in this paragraph (b)(2).
(ii) Space and ocean income derived by a controlled foreign
corporation. Space and ocean income derived by a controlled foreign
corporation within the meaning of section 957 (CFC) is income from
sources within the United States. However, space and ocean income
derived by a CFC is income from sources without the United States to
the extent the income, based on all the facts and circumstances, is
attributable to functions performed, resources employed, or risks
assumed in a foreign country or countries.
(iii) Space and ocean income derived by foreign persons engaged in
a trade or business within the United States. Space and ocean income
derived by a foreign person (other than a CFC) engaged in a trade or
business within the United States is income from sources within the
United States to the extent the income, based on all the facts and
circumstances, is attributable to functions performed, resources
employed, or risks assumed within the United States.
(3) Source rules for income from certain sales of property--(i)
Sales of purchased property. When a taxpayer sells purchased property
in space or international water, the source of gross income from the
sale generally will be determined under paragraph (b)(1) or (2) of this
section, as applicable. However, if such property is inventory property
within the meaning of section 1221(a)(1) (inventory property) and is
sold for use, consumption, or disposition outside space and
international water, the
[[Page 77604]]
source of income from the sale will be determined under Sec. 1.861-
7(c).
(ii) Sales of property produced by the taxpayer--(A) General. If
the taxpayer both produces property and sells such property, the
taxpayer must allocate gross income from such sales between production
activity and sales activity under the 50/50 method. Under the 50/50
method, one-half of the taxpayer's gross income will be considered
income allocable to production activity, and the source of that income
will be determined under paragraph (b)(3)(ii)(B) or (C) of this
section. The remaining one-half of such gross income will be considered
income allocable to sales activity, and the source of that income will
be determined under paragraph (b)(3)(ii)(D) of this section.
(B) Production only in space or international water, or only
outside space and international water. When production occurs only in
space or international water, income allocable to production activity
is sourced under paragraph (b)(1) or (2) of this section, as
applicable. When production occurs only outside space and international
water, income allocable to production activity is sourced under Sec.
1.863-3(c)(1).
(C) Production both in space or international water and outside
space and international water. When property is produced both in space
or international water and outside space and international water, gross
income allocable to production activity must be allocated to production
occurring in space or international water and production occurring
outside space and international water. Such gross income is allocated
to production activity occurring in space or international water to the
extent the income, based on all the facts and circumstances, is
attributable to functions performed, resources employed, or risks
assumed in space or international water. The balance of such gross
income is allocated to production activity occurring outside space and
international water. The source of gross income allocable to production
activity in space or international water is determined under paragraph
(b)(1) or (2) of this section, as applicable. The source of gross
income allocated to production activity occurring outside space and
international water is determined under Sec. 1.863-3(c)(1).
(D) Source of income allocable to sales activity. When property
produced by the taxpayer is sold outside space and international water,
the source of gross income allocable to sales activity will be
determined under Sec. Sec. 1.861-7(c) and 1.863-3(c)(2). When property
produced by the taxpayer is sold in space or international water, the
source of gross income allocable to sales activity generally will be
determined under paragraph (b)(1) or (2) of this section, as
applicable. However, if such property is inventory property within the
meaning of section 1221(a)(1) and is sold in space or international
water for use, consumption, or disposition outside space, international
water, and the United States, the source of gross income allocable to
sales activity will be determined under Sec. Sec. 1.861-7(c) and
1.863-3(c)(2).
(4) Special rule for determining the source of gross income from
services. To the extent a transaction characterized as the performance
of a service constitutes a space or ocean activity, as determined under
paragraph (d)(2)(ii) of this section, the source of gross income
derived from such transaction is determined under paragraph (b)(1) or
(2) of this section.
(5) Special rule for determining source of income from
communications activity (other than income from international
communications activity). Space and ocean activity, as defined in
paragraph (d) of this section, includes activity that occurs in space
or international water that is characterized as a communications
activity as defined in Sec. 1.863-9(h)(1) (other than international
communications activity). The source of space and ocean income that is
also communications income as defined in Sec. 1.863-9(h)(2) (but not
space/ocean communications income as defined in Sec. 1.863-9(h)(3)(v))
is determined under the rules of Sec. 1.863-9(c), (d), and (f), as
applicable, rather than under paragraph (b) of this section. The source
of space and ocean income that is also space/ocean communications
income as defined in Sec. 1.863-9(h)(3)(v) is determined under the
rules of paragraph (b) of this section. See Sec. 1.863-9(e).
(c) Taxable income. When a taxpayer allocates gross income under
paragraph (b)(1), (b)(2), (b)(3)(ii)(C), or (b)(4) of this section, the
taxpayer must allocate expenses, losses, and other deductions as
prescribed in Sec. Sec. 1.861-8 through 1.861-14T to the class or
classes of gross income that include the income so allocated in each
case. A taxpayer must then apply the rules of Sec. Sec. 1.861-8
through 1.861-14T to apportion properly amounts of expenses, losses,
and other deductions so allocated to such gross income between gross
income from sources within the United States and gross income from
sources without the United States.
(d) Space and ocean activity--(1) Definition--(i) Space activity.
In general, space activity is any activity conducted in space. For
purposes of this section, space means any area not within the
jurisdiction (as recognized by the United States) of a foreign country,
possession of the United States, or the United States, and not in
international water. For purposes of determining space activity, the
Commissioner may separate parts of a single transaction into separate
transactions or combine separate transactions as part of a single
transaction. Paragraph (d)(3) of this section lists specific exceptions
to the general definition of space activity. Activities that constitute
space activity include but are not limited to--
(A) Performance and provision of services in space, as defined in
paragraph (d)(2)(ii) of this section;
(B) Leasing of equipment located in space, including spacecraft
(for example, satellites) or transponders located in space;
(C) Licensing of technology or other intangibles for use in space;
(D) Production, processing, or creation of property in space, as
defined in paragraph (d)(2)(i) of this section;
(E) Activity occurring in space that is characterized as
communications activity (other than international communications
activity) under Sec. 1.863-9(h)(1);
(F) Underwriting income from the insurance of risks on activities
that produce space income; and
(G) Sales of property in space (see Sec. 1.861-7(c)).
(ii) Ocean activity. In general, ocean activity is any activity
conducted on or under water not within the jurisdiction (as recognized
by the United States) of a foreign country, possession of the United
States, or the United States (collectively, in international water).
For purposes of determining ocean activity, the Commissioner may
separate parts of a single transaction into separate transactions or
combine separate transactions as part of a single transaction.
Paragraph (d)(3) of this section lists specific exceptions to the
general definition of ocean activity. Activities that constitute ocean
activity include but are not limited to--
(A) Performance and provision of services in international water,
as defined in paragraph (d)(2)(ii) of this section;
(B) Leasing of equipment located in international water, including
underwater cables;
(C) Licensing of technology or other intangibles for use in
international water;
(D) Production, processing, or creation of property in
international water, as defined in paragraph (d)(2)(i) of this section;
[[Page 77605]]
(E) Activity occurring in international water that is characterized
as communications activity (other than international communications
activity) under Sec. 1.863-9(h)(1);
(F) Underwriting income from the insurance of risks on activities
that produce ocean income;
(G) Sales of property in international water (see Sec. 1.861-
7(c));
(H) Any activity performed in Antarctica;
(I) The leasing of a vessel that does not transport cargo or
persons for hire between ports-of-call (for example, the leasing of a
vessel to engage in research activities in international water); and
(J) The leasing of drilling rigs, extraction of minerals, and
performance and provision of services related thereto, except as
provided in paragraph (d)(3)(ii) of this section.
(2) Determining a space or ocean activity--(i) Production of
property in space or international water. For purposes of this section,
production activity means an activity that creates, fabricates,
manufactures, extracts, processes, cures, or ages property within the
meaning of section 864(a) and Sec. 1.864-1.
(ii) Special rule for performance of services--(A) General. Except
as provided in paragraph (d)(2)(ii)(B) of this section, if a
transaction is characterized as the performance of a service, then such
service will be treated as a space or ocean activity in its entirety
when any part of the service is performed in space or international
water. Services are performed in space or international water if
functions are performed, resources are employed, or risks are assumed
in space or international water, regardless of whether performed by
personnel, equipment, or otherwise.
(B) Exception to the general rule. If the taxpayer can demonstrate
the value of the service attributable to performance occurring in space
or international water, and the value of the service attributable to
performance occurring outside space and international water, then such
service will be treated as space or ocean activity only to the extent
of the activity performed in space or international water. The value of
the service is attributable to performance occurring in space or
international water to the extent the performance of the service, based
on all the facts and circumstances, is attributable to functions
performed, resources employed, or risks assumed in space or
international water. In addition, if the taxpayer can demonstrate,
based on all the facts and circumstances, that the value of the service
attributable to performance in space and international water is de
minimis, such service will not be treated as space or ocean activity.
(3) Exceptions to space or ocean activity. Space or ocean activity
does not include the following types of activities:
(i) Any activity giving rise to transportation income as defined in
section 863(c).
(ii) Any activity with respect to mines, oil and gas wells, or
other natural deposits, to the extent the mines, wells, or natural
deposits are located within the jurisdiction (as recognized by the
United States) of any country, including the United States and its
possessions.
(iii) Any activity giving rise to international communications
income as defined in Sec. 1.863-9(h)(3)(ii).
(e) Treatment of partnerships. This section is applied at the
partner level.
(f) Examples. The following examples illustrate the rules of this
section:
Example 1. Space activity--activity occurring on land and in
space--(i) Facts. S, a United States person, owns satellites in
orbit. S leases one of its satellites to A. S, as lessor, will not
operate the satellite. Part of S's performance as lessor in this
transaction occurs on land. Assume that the combination of S's
activities is characterized as the lease of equipment.
(ii) Analysis. Because the leased equipment is located in space,
the transaction is defined in its entirety as space activity under
paragraph (d)(1)(i) of this section. Income derived from the lease
will be sourced under paragraph (b)(1) of this section. Under
paragraph (b)(1) of this section, S's space income is sourced
outside the United States to the extent the income, based on all the
facts and circumstances, is attributable to functions performed,
resources employed, or risks assumed in a foreign country or
countries.
Example 2. Space activity--(i) Facts. X is an Internet service
provider. X offers a service that permits a customer (C) to connect
to the Internet via a telephone call, initiated by the modem of C's
personal computer, to a control center. X transmits information
requested by C to C's personal computer, in part using satellite
capacity leased by X from S. X performs the uplink and downlink
functions. X charges its customers a flat monthly fee. Assume that
neither X nor S derive international communications income within
the meaning of Sec. 1.863-9(h)(3)(ii). In addition, assume that X
is able to demonstrate, pursuant to paragraph (d)(2)(ii)(B) of this
section, the extent to which the value of the service is
attributable to functions performed, resources employed, and risks
assumed in space.
(ii) Analysis. Under paragraph (d)(2)(ii) of this section, the
service performed by X constitutes space activity to the extent the
value of the service is attributable to functions performed,
resources employed, and risks assumed in space. To the extent the
service performed by X constitutes space activity, the source of X's
income from the service transaction is determined under paragraph
(b) of this section. To the extent the service performed by X does
not constitute space or ocean activity, the source of X's income
from the service is determined under sections 861, 862, and 863, as
applicable. To the extent that X derives space and ocean income that
is also communications income within the meaning of Sec. 1.863-
9(h)(2), the source of X's income is determined under paragraph (b)
of this section and Sec. 1.863-9(c), (d), and (f), as applicable,
as provided in paragraph (b)(5) of this section. S derives space and
ocean income that is also communications income within the meaning
of Sec. 1.863-9(h)(2), and the source of S's income is therefore
determined under paragraph (b) of this section and Sec. 1.863-9(c),
(d), and (f), as applicable, as provided in paragraph (b)(5) of this
section.
Example 3. Services as space activity--de minimis value
attributable to performance occurring in space--(i) Facts. R owns a
retail outlet in the United States. R engages S to provide a
security system for R's premises. S operates its security system by
transmitting images from R's premises directly to a satellite, and
from the satellite to a group of S employees located in Country B,
who monitor the premises by viewing the transmitted images. The
satellite is used as a medium of delivery and not as a method of
surveillance. O provides S with transponder capacity on O's
satellite, which S uses to transmit those images. Assume that S's
transaction with R is characterized as the performance of a service.
Assume that O's provision of transponder capacity is also viewed as
the provision of a service. Assume also that S is able to
demonstrate, pursuant to Sec. 1.863-9(h)(1), that the value of the
transaction with R attributable to communications activities is de
minimis.
(ii) Analysis. S derives income from providing monitoring
services. S can demonstrate, pursuant to paragraph (d)(2)(ii) of
this section, that based on all the facts and circumstances, the
value of S's service transaction attributable to performance in
space is de minimis. Thus, S is not treated as engaged in a space
activity, and none of S's income from the service transaction is
space income. In addition, because S demonstrates that the value of
the transaction with R attributable to communications activities is
de minimis, S is not required under Sec. 1.863-9(h)(1)(ii) to treat
the transaction as separate communications and non-communications
transactions, and none of S's gross income from the transaction is
treated as communications income within the meaning of Sec. 1.863-
9(h)(2). O's provision of transponder capacity is viewed as the
provision of a service. Based on all the facts and circumstances,
the value of O's service transaction attributable to performance
[[Page 77606]]
in space is not de minimis. Thus, O's activity will be considered
space activity, pursuant to paragraph (d)(2)(ii) of this section, to
the extent the value of the services transaction is attributable to
performance in space (unless O's activity in space is international
communications activity). To the extent that O derives
communications income, the source of such income is determined under
paragraph (b) of this section and Sec. 1.863-9(b), (c), (d), and
(f), as applicable, as provided in paragraph (b)(5) of this section.
R does not derive any income from space activity.
Example 4. Space activity--(i) Facts. L, a domestic corporation,
offers programming and certain other services to customers located
both in the United States and in foreign countries. Assume that L's
provision of programming and other services in this Example 4 is
characterized as the provision of a service, and that no part of the
service transaction occurs in space or international water. Assume
that the delivery of the programming constitutes a separate
transaction also characterized as the performance of a service. L
uses satellite capacity acquired from S to deliver the programming
service directly to customers' television sets. L performs the
uplink and downlink functions, so that part of the value of the
delivery transaction derives from functions performed and resources
employed in space. Assume that these contributions to the value of
the delivery transaction occurring in space are not considered de
minimis under paragraph (d)(2)(ii)(B) of this section. Customer C
pays L to provide and deliver programming to C's residence in the
United States. Assume S's provision of satellite capacity in this
Example 4 is viewed as the provision of a service, and also that S
does not derive international communications income within the
meaning of Sec. 1.863-9(h)(3)(ii).
(ii) Analysis. S's activity will be considered space activity.
To the extent that S derives space and ocean income that is also
communications income under Sec. 1.863-9(h)(2), the source of S's
income is determined under paragraph (b) of this section and Sec.
1.863-9(c), (d), and (f), as applicable, as provided in paragraph
(b)(5) of this section. On these facts, L's activities are treated
as two separate service transactions: the provision of programming
(and other services), and the delivery of programming. L's income
derived from provision of programming and other services is not
income derived from space activity. L's delivery of programming and
other services is considered space activity, pursuant to paragraph
(d)(2)(ii) of this section, to the extent the value of the delivery
transaction is attributable to performance in space. To the extent
that the delivery of programming is treated as a space activity, the
source of L's income derived from the delivery transaction is
determined under paragraph (b)(1) of this section, as provided in
paragraph (b)(4) of this section. To the extent that L derives space
and ocean income that is also communications income within the
meaning of Sec. 1.863-9(h)(2), the source of such income is
determined under paragraph (b) of this section and Sec. 1.863-9(b),
(c), (d), (e), and (f), as applicable, as provided in paragraph
(b)(5) of this section.
Example 5. Space activity--(i) Facts. The facts are the same as
in Example 4, except that L does not deliver the programming service
directly but instead engages R, a domestic corporation specializing
in content delivery, to deliver by transmission its programming. For
all portions of a transmission which require satellite capacity, R,
in turn, contracts out such functions to S. S performs the uplink
and downlink functions, so that part of the value of the delivery
transaction derives from functions performed and resources employed
in space.
(ii) Analysis. L's activity will not be considered space
activity because none of L's activity occurs in space. Thus, L does
not derive any space and ocean income. L does, however, derive
communications income within the meaning of Sec. 1.863-9(h)(2).
This is the case even though L does not perform the transmission
function because L is paid by Customer C to transmit, and bears the
risk of transmitting, the communications or data. To the extent that
L's activity consists in part of non-de minimis communications and
non-de minimis non-communications activity, each part of the
transaction must be treated as a separate transaction and gross
income is allocated accordingly under Sec. 1.863-9(h)(1)(ii). In
addition, L must also allocate expenses, losses, and other
deductions, for example, payments to R, to the class or classes of
gross income that include the income so allocated. R's activity will
not be considered space activity. Since R contracts out all of the
functions involving satellite capacity to S, no part of R's activity
occurs in space. Thus, R does not derive any space and ocean income.
R does, however, derive communications income within the meaning of
Sec. 1.863-9(h)(2). This is the case even though R does not perform
the transmission function because R is paid by L to transmit, and
bears the risk of transmitting, the communications or data. S's
activity will be considered space activity. To the extent that S
derives space and ocean income that is also communications income
within the meaning of Sec. 1.863-9(h)(2), the source of such income
is determined under paragraph (b) of this section and Sec. 1.863-
9(b), (c), (d), (e), and (f), as applicable, as provided in
paragraph (b)(5) of this section.
Example 6. Space activity--treatment of land activity--(i)
Facts. S, a United States person, offers remote imaging products and
services to its customers. In year 1, S uses its satellite's remote
sensors to gather data on certain geographical terrain. In year 3,
C, a construction development company, contracts with S to obtain a
satellite image of an area for site development work. S pulls data
from its archives and transfers to C the images gathered in year 1,
in a transaction that is characterized as a sale of the data. S's
rights, title, and interest in the data pass to C in the United
States. Before transferring the images to C, S uses computer
software in its land-based office to enhance the images so that the
images can be used.
(ii) Analysis. The collection of data and creation of images in
space is characterized as the creation of property in space. Because
S both produces and sells the data, S must allocate gross income
from the sale of the data between production activity and sales
activity under the 50/50 method of paragraph (b)(3)(ii)(A). The
source of S's income allocable to production activity is determined
under paragraph (b)(3)(ii)(C) of this section because production
activities occur both in space and on land. The source of S's income
attributable to sales activity is determined under paragraph
(b)(3)(ii)(D) of this section (by reference to Sec. 1.863-3(c)(2))
as U.S. source income because S's rights, title, and interest in the
data pass to C in the United States.
Example 7. Use of intangible property in space--(i) Facts. X
acquires a license to use a particular satellite slot or orbit,
which X sublicenses to C. C pays X a royalty.
(ii) Analysis. Because the royalty is paid for the right to use
intangible property in space, the source of the royalty paid by C to
X is determined under paragraph (b) of this section.
Example 8. Performance of services--(i) Facts. E, a domestic
corporation, operates satellites with sensing equipment that can
determine how much heat and light particular plants emit and
reflect. Based on the data, E will provide F, a U.S. farmer, a
report analyzing the data, which F will use in growing crops. E
analyzes the data from offices located in the United States. Assume
that E's combined activities are characterized as the performance of
services.
(ii) Analysis. Based on all the facts and circumstances, the
value of E's service transaction attributable to performance in
space is not de minimis. Thus, E's activities will be considered
space activities, pursuant to paragraph (d)(2)(ii) of this section,
to the extent the value of E's service transaction is attributable
to performance in space. To the extent E's service transaction
constitutes a space activity, the source of E's income derived from
the service transaction will be determined under paragraph (b)(4) of
this section, by reference to paragraph (b)(1) of this section. To
the extent that E's service transaction does not constitute a space
or ocean activity, the source of E's income derived from the service
transaction is determined under sections 861, 862, and 863, as
applicable.
Example 9. Separate transactions--(i) Facts. The same facts as
Example 8, except that E provides the raw data to F in a transaction
characterized as a sale of a copyrighted article. In addition, E
provides an analysis in the form of a report to F. The price F pays
E for the raw data is separately stated.
(ii) Analysis. To the extent that the provision of raw data and
the analysis of the data are each treated as separate transactions,
the source of income from the production and sale of data is
determined under paragraph (b)(3)(ii) of this section. The provision
of services would be analyzed in the same manner as in Example 8.
Example 10. Sale of property in international water--(i) Facts.
T purchased and owns transatlantic cable that lies in international
water. T sells the cable to B, with T's rights, title, and interest
in the cable
[[Page 77607]]
passing to B in international water. Assume that the transatlantic
cable is not inventory property within the meaning of section
1221(a)(1).
(ii) Analysis. Because T's rights, title, and interest in the
property pass to B in international water, the sale takes place in
international water under Sec. 1.861-7(c), and the sale transaction
is ocean activity under paragraph (d)(1)(ii) of this section. The
source of T's sales income is determined under paragraph (b)(3)(i)
of this section, by reference to paragraph (b)(1) or (2) of this
section.
Example 11. Sale of property in space--(i) Facts. S, a United
States person, manufactures a satellite in the United States and
sells it to a customer who is not a United States person. S's
rights, title, and interest in the satellite pass to the customer in
space.
(ii) Analysis. Because S's rights, title, and interest in the
satellite pass to the customer in space, the sale takes place in
space under Sec. 1.861-7(c), and the sale transaction is space
activity under paragraph (d)(1)(i) of this section. The source of
income derived from the sale of the satellite in space is determined
under paragraph (b)(3)(ii) of this section, with the source of
income allocable to production activity determined under paragraphs
(b)(3)(ii)(A) and (B) of this section, and the source of income
allocable to sales activity determined under paragraphs
(b)(3)(ii)(A) and (D) of this section. Under paragraph (b)(1) of
this section, S's space income is sourced outside the United States
to the extent the income, based on all the facts and circumstances,
is attributable to functions performed, resources employed, or risks
assumed in a foreign country or countries.
Example 12. Sale of property in space--(i) Facts. S has a right
to operate from a particular position (satellite slot or orbit) in
space. S sells the right to operate from that position to P. Assume
that the sale of the satellite slot is characterized as a sale of
property and that S's rights, title, and interest in the satellite
slot pass to P in space.
(ii) Analysis. The sale of the satellite slot takes place in
space under Sec. 1.861-7(c) because S's rights, title, and interest
in the satellite slot pass to P in space. The sale of the satellite
slot is space activity under paragraph (d)(1)(i) of this section,
and income or gain from the sale is sourced under paragraph
(b)(3)(i) of this section, by reference to paragraph (b)(1) or (2)
of this section.
Example 13. Source of income of a foreign person--(i) Facts. FP,
a foreign corporation that is not a CFC, derives income from the
operation of satellites. FP operates ground stations in the United
States and in foreign Country FC. Assume that FP is considered
engaged in a trade or business within the United States based on
FP's operation of the ground station in the United States.
(ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP's
space income is sourced in the United States to the extent the
income, based on all the facts and circumstances, is attributable to
functions performed, resources employed, or risks assumed within the
United States.
Example 14. Source of income of a foreign person--(i) Facts. FP,
a foreign corporation that is not a CFC, operates remote sensing
satellites in space to collect data and images for its customers. FP
uses an independent agent, A, in the United States who provides
marketing, order-taking, and other customer service functions.
Assume that FP is considered engaged in a trade or business within
the United States based on A's activities on FP's behalf in the
United States.
(ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP's
space income is sourced in the United States to the extent the
income, based on all the facts and circumstances, is attributable to
functions performed, resources employed, or risks assumed within the
United States.
(g) Reporting and documentation requirements--(1) In general. A
taxpayer making an allocation of gross income under paragraph (b)(1),
(b)(2), (b)(3)(ii)(C), or (b)(4) of this section must satisfy the
requirements in paragraphs (g)(2), (3), and (4) of this section.
(2) Required documentation. In all cases, a taxpayer must prepare
and maintain documentation in existence when its return is filed
regarding the allocation of gross income and allocation and
apportionment of expenses, losses, and other deductions, the
methodologies used, and the circumstances justifying use of those
methodologies. The taxpayer must make available such documentation
within 30 days upon request.
(3) Access to software. If the taxpayer or any third party used any
computer software, within the meaning of section 7612(d), to allocate
gross income, or to allocate or apportion expenses, losses, and other
deductions, the taxpayer must make available upon request--
(i) Any computer software executable code, within the meaning of
section 7612(d), used for such purposes, including an executable copy
of the version of the software used in the preparation of the
taxpayer's return (including any plug-ins, supplements, etc.) and a
copy of all related electronic data files. Thus, if software
subsequently is upgraded or supplemented, a separate executable copy of
the version used in preparing the taxpayer's return must be retained;
(ii) Any related computer software source code, within the meaning
of section 7612(d), acquired or developed by the taxpayer or a related
person, or primarily for internal use by the taxpayer or such person
rather than for commercial distribution; and
(iii) In the case of any spreadsheet software or similar software,
any formulae or links to supporting worksheets.
(4) Use of allocation methodology. In general, when a taxpayer
allocates gross income under paragraph (b)(1), (b)(2), (b)(3)(ii)(C),
or (b)(4) of this section, it does so by making the allocation on a
timely filed original return (including extensions). However, a
taxpayer will be permitted to make changes to such allocations made on
its original return with respect to any taxable year for which the
statute of limitations has not closed as follows:
(i) In the case of a taxpayer that has made a change to such
allocations prior to the opening conference for the audit of the
taxable year to which the allocation relates or who makes such a change
within 90 days of such opening conference, if the IRS issues a written
information document request asking the taxpayer to provide the
documents and such other information described in paragraphs (g)(2) and
(3) of this section with respect to the changed allocations and the
taxpayer complies with such request within 30 days of the request, then
the IRS will complete its examination, if any, with respect to the
allocations for that year as part of the current examination cycle. If
the taxpayer does not provide the documents and information described
in paragraphs (g)(2) and (3) of this section within 30 days of the
request, then the procedures described in paragraph (g)(4)(ii) of this
section shall apply.
(ii) If the taxpayer changes such allocations more than 90 days
after the opening conference for the audit of the taxable year to which
the allocations relate or the taxpayer does not provide the documents
and information with respect to the changed allocations as requested in
accordance with paragraphs (g)(2) and (3) of this section, then the IRS
will, in a separate cycle, determine whether an examination of the
taxpayer's allocations is warranted and complete any such examination.
The separate cycle will be worked as resources are available and may
not have the same estimated completion date as the other issues under
examination for the taxable year. The IRS may ask the taxpayer to
extend the statute of limitations on assessment and collection for the
taxable year to permit examination of the taxpayer's method of
allocation, including an extension limited, where appropriate, to the
taxpayer's method of allocation.
(h) Effective date. This section applies to taxable years beginning
on or after December 27, 2006.
Sec. 1.863-9 Source of income derived from communications activity
under section 863(a), (d), and (e).
(a) In general. Income of a United States or a foreign person
derived from each type of communications activity, as defined in
paragraph (h)(3) of this
[[Page 77608]]
section, is sourced under the rules of this section, notwithstanding
any other provision including sections 861, 862, 863, and 865.
Notwithstanding that a communications activity would qualify as space
or ocean activity under section 863(d) and the regulations thereunder,
the source of income derived from such communications activity is
determined under this section, and not under section 863(d) and the
regulations thereunder, except to the extent provided in Sec. 1.863-
8(b)(5).
(b) Source of international communications income--(1)
International communications income derived by a United States person.
Income derived from international communications activity
(international communications income) by a United States person is one-
half from sources within the United States and one-half from sources
without the United States.
(2) International communications income derived by foreign
persons--(i) In general. International communications income derived by
a person other than a United States person is, except as otherwise
provided in this paragraph (b)(2), wholly from sources without the
United States.
(ii) International communications income derived by a controlled
foreign corporation. International communications income derived by a
controlled foreign corporation within the meaning of section 957 (CFC)
is one-half from sources within the United States and one-half from
sources without the United States.
(iii) International communications income derived by foreign
persons with a fixed place of business in the United States.
International communications income derived by a foreign person, other
than a CFC, that is attributable to an office or other fixed place of
business of the foreign person in the United States is from sources
within the United States. The principles of section 864(c)(5) apply in
determining whether a foreign person has an office or fixed place of
business in the United States. See Sec. 1.864-7. International
communications income is attributable to an office or other fixed place
of business to the extent of functions performed, resources employed,
or risks assumed by the office or other fixed place of business.
(iv) International communications income derived by foreign persons
engaged in a trade or business within the United States. International
communications income derived by a foreign person (other than a CFC)
engaged in a trade or business within the United States is income from
sources within the United States to the extent the income, based on all
the facts and circumstances, is attributable to functions performed,
resources employed, or risks assumed within the United States.
(c) Source of U.S. communications income. Income derived by a
United States or foreign person from U.S. communications activity is
from sources within the United States.
(d) Source of foreign communications income. Income derived by a
United States or foreign person from foreign communications activity is
from sources without the United States.
(e) Source of space/ocean communications income. The source of
income derived by a United States or foreign person from space/ocean
communications activity is determined under section 863(d) and the
regulations thereunder.
(f) Source of communications income when taxpayer cannot establish
the two points between which the taxpayer is paid to transmit the
communication. Income derived by a United States or foreign person from
communications activity, when the taxpayer cannot establish the two
points between which the taxpayer is paid to transmit the communication
as required in paragraph (h)(3)(i) of this section, is from sources
within the United States.
(g) Taxable income. When a taxpayer allocates gross income under
paragraph (b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section, the
taxpayer must allocate expenses, losses, and other deductions as
prescribed in Sec. Sec. 1.861-8 through 1.861-14T to the class or
classes of gross income that include the income so allocated in each
case. A taxpayer must then apply the rules of Sec. Sec. 1.861-8
through 1.861-14T properly to apportion amounts of expenses, losses,
and other deductions so allocated to such gross income between gross
income from sources within the United States and gross income from
sources without the United States. For amounts of expenses, losses, and
other deductions allocated to gross income derived from international
communications activity, when the source of income is determined under
the 50/50 method of paragraph (b)(1) or (b)(2)(ii) of this section,
taxpayers generally must apportion expenses, losses, and other
deductions between sources within the United States and sources without
the United States pro rata based on the relative amounts of gross
income from sources within the United States and gross income from
sources without the United States. However, the preceding sentence
shall not apply to research and experimental expenditures qualifying
under Sec. 1.861-17, which are to be allocated and apportioned under
the rules of that section.
(h) Communications activity and income derived from communications
activity--(1) Communications activity--(i) General rule. For purposes
of this part, communications activity consists solely of the delivery
by transmission of communications or data (communications). Delivery of
communications other than by transmission (for example, by delivery of
physical packages and letters) is not communications activity within
the meaning of this section. Communications activity also includes the
provision of capacity to transmit communications. Provision of content
or any other additional service provided along with, or in connection
with, a non-de minimis communications activity must be treated as a
separate non-communications activity unless de minimis. Communications
activity or non-communications activity will be treated as de minimis
to the extent, based on the facts and circumstances, the value
attributable to such activity is de minimis.
(ii) Separate transaction. To the extent that a taxpayer's
transaction consists in part of non-de minimis communications activity
and in part of non-de minimis non-communications activity, each such
part of the transaction must be treated as a separate transaction.
Gross income is allocated to each such communications activity
transaction and non-communications activity transaction to the extent
the income, based on all the facts and circumstances, is attributable
to functions performed, resources employed, or risks assumed in each
such activity.
(2) Income derived from communications activity. Income derived
from communications activity (communications income) is income derived
from the delivery by transmission of communications, including income
derived from the provision of capacity to transmit communications.
Income may be considered derived from a communications activity even if
the taxpayer itself does not perform the transmission function, but in
all cases, the taxpayer derives communications income only if the
taxpayer is paid to transmit, and bears the risk of transmitting, the
communications.
(3) Determining the type of communications activity--(i) In
general. Whether income is derived from international communications
activity, U.S. communications activity, foreign communications
activity, or space/
[[Page 77609]]
ocean communications activity is determined by identifying the two
points between which the taxpayer is paid to transmit the
communication. The taxpayer must establish the two points between which
the taxpayer is paid to transmit, and bears the risk of transmitting,
the communication. Whether the taxpayer contracts out part or all of
the transmission function is not relevant. A taxpayer may satisfy the
requirement that the taxpayer establish the two points between which
the taxpayer is paid to transmit, and bears the risk of transmitting,
the communication by using any consistently applied reasonable method
to establish one or both endpoints. In evaluating the reasonableness of
such method, consideration will be given to all the facts and
circumstances, including whether the endpoints would otherwise be
identifiable absent this reasonable method provision and the
reliability of the data. Depending on the facts and circumstances,
methods based on, for example, records of port or transport charges,
customer billing records, a satellite footprint, or records of
termination fees made pursuant to an international settlement agreement
may be reasonable. In addition, practices used by taxpayers to classify
or categorize certain communications activity in connection with
preparation of statements and analyses for the use of management,
creditors, minority shareholders, joint ventures, or other parties or
governmental agencies in interest may be reliable indicators of the
reasonableness of the method chosen, but need not be accorded
conclusive weight by the Commissioner. In all cases, the method chosen
to establish the two points between which the taxpayer is paid to
transmit, and bears the risk of transmitting, the communication must be
supported by sufficient documentation to permit verification by the
Commissioner.
(ii) Income derived from international communications activity.
Income derived by a taxpayer from international communications activity
(international communications income) is income derived from
communications activity, as defined in paragraph (h)(2) of this
section, when the taxpayer is paid to transmit--
(A) Between a point in the United States and a point in a foreign
country (or a possession of the United States); or
(B) Foreign-originating communications (communications with a
beginning point in a foreign country or a possession of the United
States) from a point in space or international water to a point in the
United States.
(iii) Income derived from U.S. communications activity. Income
derived by a taxpayer from U.S. communications activity (U.S.
communications income) is income derived from communications activity,
as defined in paragraph (h)(2) of this section, when the taxpayer is
paid to transmit--
(A) Between two points in the United States; or
(B) Between the United States and a point in space or international
water, except as provided in paragraph (h)(3)(ii)(B) of this section.
(iv) Income derived from foreign communications activity. Income
derived by a taxpayer from foreign communications activity (foreign
communications income) is income derived from communications activity,
as defined in paragraph (h)(2) of this section, when the taxpayer is
paid to transmit--
(A) Between two points in a foreign country or countries (or a
possession or possessions of the United States);
(B) Between a foreign country and a possession of the United
States; or
(C) Between a foreign country (or a possession of the United
States) and a point in space or international water.
(v) Income derived from space/ocean communications activity. Income
derived by a taxpayer from space/ocean communications activity (space/
ocean communications income) is income derived from communications
activity, as defined in paragraph (h)(2) of this section, when the
taxpayer is paid to transmit between a point in space or international
water and another point in space or international water.
(i) Treatment of partnerships. This section is applied at the
partner level.
(j) Examples. The following examples illustrate the rules of this
section:
Example 1. Income derived from non-communications activity--
remote data base access--(i) Facts. D provides its customers in
various foreign countries with access to its data base, which
contains information on certain individuals' health care insurance
coverage. Customer C obtains access to D's data base by placing a
call to D's telephone number. Assume that C's telephone service,
used to access D's data base, is provided by a third party, and that
D assumes no responsibility for the transmission of the information
via telephone.
(ii) Analysis. D is not paid to transmit communications and does
not derive income from communications activity within the meaning of
paragraph (h)(2) of this section. Rather, D derives income from
provision of content or provision of services to its customers.
Therefore, the rules of this section do not apply to determine the
source of D's income.
Example 2. Income derived from U.S. communications activity--
U.S. portion of international communication--(i) Facts. TC, a local
telephone company, receives an access fee from an international
carrier for picking up a call from a local telephone customer and
delivering the call to a U.S. point of presence (POP) of the
international carrier. The international carrier picks up the call
from its U.S. POP and delivers the call to a foreign country.
(ii) Analysis. TC is not paid to carry the transmission between
the United States and a foreign country. TC is paid to transmit a
communication between two points in the United States. TC derives
U.S. communications income as defined in paragraph (h)(3)(iii) of
this section, which is sourced under paragraph (c) of this section
as U.S. source income.
Example 3. Income derived from international communications
activity--underwater cable--(i) Facts. TC, a domestic corporation,
owns an underwater fiber optic cable. Pursuant to contracts, TC
makes available to its customers capacity to transmit communications
via the cable. TC's customers then solicit telephone customers and
arrange to transmit the telephone customers' calls. The cable runs
in part through U.S. waters, in part through international waters,
and in part through foreign country waters.
(ii) Analysis. TC derives international communications income as
defined in paragraph (h)(3)(ii) of this section because TC is paid
to make available capacity to transmit communications between the
United States and a foreign country. Because TC is a United States
person, TC's international communications income is sourced under
paragraph (b)(1) of this section as one-half from sources within the
United States and one-half from sources without the United States.
Example 4. Income derived from international communications
activity--satellite--(i) Facts. S, a United States person, owns
satellites in orbit and uplink facilities in Country X, a foreign
country. B, a resident of Country X, pays S to deliver B's
programming from S's uplink facility, located in Country X, to a
downlink facility in the United States owned by C, a customer of B.
(ii) Analysis. S derives international communications income
under paragraph (h)(3)(ii) of this section because S is paid to
transmit the communications between a beginning point in a foreign
country and an endpoint in the United States. Because S is a United
States person, the source of S's international communications income
is determined under paragraph (b)(1) of this section as one-half
from sources within the United States and one-half from sources
without the United States.
Example 5. The paid-to-do rule--foreign communications via
domestic route--(i)
[[Page 77610]]
Facts. TC is paid to transmit communications from Toronto, Canada,
to Paris, France. TC transmits the communications from Toronto to
New York. TC pays another communications company, IC, to transmit
the communications from New York to Paris.
(ii) Analysis. Under the paid-to-do rule of paragraph (h)(3)(i)
of this section, TC derives foreign communications income under
paragraph (h)(3)(iv) of this section because TC is paid to transmit
communications between two points in foreign countries, Toronto and
Paris. Under paragraph (h)(3)(i) of this section, the character of
TC's communications activity is determined without regard to the
fact that TC pays IC to transmit the communications for some portion
of the delivery path. IC has international communications income
under paragraph (h)(3)(ii) of this section because IC is paid to
transmit the communications between a point in the United States and
a point in a foreign country.
Example 6. The paid-to-do rule--domestic communication via
foreign route--(i) Facts. TC is paid to transmit a call between two
points in the United States, but routes the call through Canada.
(ii) Analysis. Under paragraph (h)(3)(i) of this section, the
character of income derived from communications activity is
determined by the two points between which the taxpayer is paid to
transmit, and bears the risk of transmitting, the communications,
without regard to the path of the transmission between those two
points. Thus, under paragraph (h)(3)(iii) of this section, TC
derives income from U.S. communications activity because it is paid
to transmit the communications between two U.S. points.
Example 7. The paid-to-do rule--foreign-originating
communications--(i) Facts. Under an international settlement
agreement, G, a Country X international carrier, pays T to receive
all calls originating in Country X that are bound for the United
States and to terminate such calls in the United States. Due to
Country X legal restrictions, the international settlement agreement
specifies that G carries the transmission to a point outside the
territory of Country X and that T carries the foreign-originating
transmission from such point to the destined point in the United
States. T, in turn, contracts out with another communications
company, S, to transmit the U.S. portion of the communications.
Tracing and identifying the endpoints of each transmission is not
possible or practical. T does, however, keep records of termination
fees received from G for terminating the foreign-originating calls.
(ii) Analysis. T derives communications income as defined in
paragraph (h)(2) of this section. Based on all the facts and
circumstances, T can establish that T is paid to transmit, and bears
the risk of transmitting, foreign-originating calls from a point in
space or international water to a point in the United States using a
reasonable method to establish the endpoints, assuming that this
method is consistently applied. In this case, T can reasonably
establish that T is paid to receive foreign-originating calls and
terminate such calls in the United States based on the records of
termination fees pursuant to an international settlement agreement.
Under paragraph (h)(3)(ii)(B) of this section, a taxpayer derives
income from international communications activity when the taxpayer
is paid to transmit foreign-originating communications from space or
international water to the United States. Thus, under paragraph
(h)(3)(ii)(B) of this section, T derives income from international
communications. If, based on all the facts and circumstances, T
could reasonably trace and identify the endpoints, then T would have
to directly establish that each call originated in a foreign
country. Assuming T is able to do so, the rest of the analysis in
this Example 7 remains the same. Under paragraph (h)(3)(iii) of this
section, S derives income from U.S. communications activity because
S is paid to transmit the communications between two U.S. points.
Example 8. Indeterminate endpoints--prepaid telephone calling
cards--(i) Facts. S purchases capacity from TC to transmit telephone
calls. S sells prepaid telephone calling cards that give customers
access to TC's telephone lines for a certain number of minutes.
Assume that S cannot establish the endpoints of its customers'
telephone calls, even under the reasonable method rule of paragraph
(h)(3) of this section.
(ii) Analysis. S derives communications income as defined in
paragraph (h)(2) of this section because S makes capacity to
transmit communications available to its customers. In this case, S
cannot establish the two points between which the communications are
transmitted. Therefore, S's communications income is U.S. source
income, as provided by paragraph (f) of this section.
Example 9. Reasonable methods--minutes of use data on long
distance calling plans--(i)Facts. B provides both domestic and
international long distance services in a calling plan for a limited
number of minutes for a set amount each month. Tracing and
identifying the endpoints of each transmission is not possible or
practical. B is, however, able to establish that the calling plan
generated $10,000 of revenue for 25,000 minutes based on reports
derived from customer billing records. Based on minutes of use data
in these reports, B is able to establish that of the total 25,000
minutes, 60 percent or 15,000 minutes were for U.S. long distance
calls and 40 percent or 10,000 minutes were for international calls.
(ii) Analysis. B derives communications income as defined in
paragraph (h)(2) of this section. Based on all the facts and
circumstances, B can establish the two points between which B is
paid to transmit, and bears the risk of transmitting, the
communications using a reasonable method to establish the endpoints,
assuming that this method is consistently applied. In this case, B
can reasonably establish that 60 percent of the income derived from
the long distance calling plan is U.S. communications income and 40
percent is international communications income based on the minutes
of use data derived from customer billing records to establish the
endpoints of the communications. If, based on all the facts and
circumstances, B could reasonably trace and identify the endpoints,
then B would have to directly identify the endpoints between which B
is paid to transmit the communications.
Example 10. Reasonable methods--system design--(i) Facts. D
operates satellites which are designed to transmit signals through
two separate ranges of signal frequencies (bands). Due to
technological limitations, requirements, and practicalities, one
band is designed to only transmit signals within the United States.
The other band is designed to transmit signals between foreign
countries and the United States. D cannot trace and identify the
endpoints of each individual transmission. D does, however, track
the total transmission through each band and the total income
derived from transmitting signals through each band.
(ii) Analysis. D derives communications income as defined in
paragraph (h)(2) of this section. Based on all the facts and
circumstances, D can establish the two points between which D is
paid to transmit, and bears the risk of transmitting, the
communications using a reasonable method to establish endpoints,
assuming that this method is consistently applied. In this case, D
can reasonably establish that income derived from transmissions
through the first band is U.S. communications income and income
derived from transmissions through the second band is international
communications income based on the design of the bands to establish
the endpoints of the communications.
Example 11. Reasonable methods--port locations--(i) Facts. X
provides its customer, C, with a virtual private network (VPN) so
that C's U.S. headquarter office canconnect and communicate with
offices in the United States, Country X, Country Y, and Country Z.
Assume that the VPN is only for communications with the U.S.
headquarter office. X cannot trace and identify the endpoints of
each transmission. C pays X a set amount each month for the entire
service, regardless of the magnitude of the usage or the geographic
points between which C uses the service.
(ii) Analysis. X derives communications income as defined in
paragraph (h)(2) of this section. Based on the facts and
circumstances, X can establish the two points between which X is
paid to transmit, and bears the risk of transmitting, the
communications using a reasonable method to establish endpoints,
assuming that this method is consistently applied. In this case, X
can reasonably establish that one-fourth of the income derived from
the VPN service is U.S. communications income and three-fourths is
international communications income based on the loca